In the United States, the Internal Revenue Service (IRS) reports that employees having payroll income with mandatory withholding amounts deducted from their pay are 98% tax compliant, clearly demonstrating that systematic set-asides of tax liabilities on a frequent, periodic basis, typically every week or every two weeks, almost entirely relieves taxpayers, and their accountants, of the wasteful and worrisome burden of delinquencies, penalties, enforcements, and workout plans. In contrast to this scenario, the IRS estimates that out of the 29 million self-employed individuals in the United States, only 40% are compliant in paying their estimated taxes in full and on time.
The direct financial consequence of non-compliance is illustrated in the following table, which is based upon a single U.S. resident, self-employed, using the standard deductions for tax year 2007, who makes no estimated tax payments:
TABLE 1IncomeTaxIRS Underpayment Penalty$30,000$6,717$306$50,000$12,990$588$100,000$31,810$1,448
There are also indirect, quality-of-life consequences that can arise from estimated tax non-compliance. The IRS can file tax liens and the individual's credit, reputation, and peace of mind can be impaired. The individual may then be afraid to maintain a bank account due to fear of an IRS levy. It may become difficult for the individual to lease a car, buy a house, or obtain a credit card due to impaired credit. The filing of separate tax returns to keep a spouse's credit clean may result in the unnecessary payment of thousands of dollars in extra taxes, due to the bracket break between MFS (married filing separately) and MFJ (married filing jointly). And ultimately, a delinquent taxpayer, out of desperation, may stop filing tax returns altogether, and then may become liable for additional civil and criminal penalties.
One approach for a self-employed individual is to divide the estimated annual tax liability into smaller amounts that can be set aside monthly, weekly, or according to whatever set-aside period the individual prefers. For example, the individual can establish a separate set-aside bank account for accumulating estimated taxes, and can arrange for his or her bank to automatically transfer a fixed amount from a checking account into the set-aside account every week, every month, or according to whatever set-aside period the individual chooses. Estimated taxes can then be paid from the set-aside account as they come due.
This set-aside practice has been recommended to clients by more than 70% of accountants surveyed, yet it is almost never followed, due to many drawbacks and complications. In the US, estimated tax payments are due on April 15th, June 15th, September 15th, and January 15th. These due-dates divide the tax year into estimated tax intervals which vary in length from 8 weeks to 18 weeks, or from two months to four months. Therefore, simply dividing the annual tax liability into equal, smaller amounts to be set aside every week or every month will result in shortfalls and penalties in two quarters. The set-aside amount can be manually recalculated and adjusted for each estimated tax interval, but this can be burdensome to the tax payer, and will result in significant fluctuations from interval to interval in the amounts transferred to the set-aside account.
In addition, self-employed individuals frequently receive their incomes at unequal and even unpredictable rates, and the total amount of income for a self-employed individual's tax year may be difficult to predict. This can lead to frequent adjustment of the estimated tax liability, and frequent re-calculation of the set-aside amounts, as income fluctuates during the course of a tax year. And even if self employment income is somewhat steady and predictable, adjustments may be required after calculation and payment in April of the previous year's taxes.
Cash shortfalls may also necessitate adjusting or missing some periodic set-asides, or even underpaying or missing an estimated tax payment, and may therefore require re-calculation and adjustment of the set-aside amounts. Beginning the set-aside process after a tax year has begun can further complicate the scheduling of appropriate set-asides, and may require adjustment of the set-aside amounts so as to compensate for estimated tax payments that have already been missed and/or overpayments that have already been made.
In addition, an individual may be reluctant to accrue funds in advance of estimated tax payments in case an unexpected need for cash should arise, for example due to an unexpected self-employment expense or investment opportunity.
For the reasons given above, many self-employed individuals and business owners (many of whom lack sufficient regimentation and discipline) have found it too difficult and too burdensome to calculate and set-aside appropriate amounts of estimated tax revenue on a frequent, regular basis, despite the clear and significant benefits that would be realized therefrom. For example: $19.25 per week (which is highly affordable), would add up to over $1,000 dollars at the end of a year (which is far less affordable), yet this approach is rarely implemented.
While the preceding discussion is focused on estimated tax payments, other circumstances can give rise to similar revenue set-aside best practices, needs, and difficulties. For example, when income is unpredictable, it can be difficult to calculate appropriate set-aside amounts for payment of child support, alimony, church contribution commitments, retirement savings, home mortgages, savings accounts, emergency funds, and such like. In other examples, the financial obligation itself may vary, depending on the amount and timing of current income rather than a prior year income or tax, or on some other current variable such as sales, or even a non-financial variable such as incremental usage of a resource, resulting in a varying obligation that affects an optimal schedule of payments. In some circumstances, such as church “tithing” contributions, the total amount to be paid can depend on a payer's income, requiring that set-aside amounts be adjusted according to changes in actual and/or predicted income.